The Contribution Margin Ratio
Managers are often faced with the challenge of figuring out which products to focus on in order to make the most profit. This decision can be difficult to make, especially when the product range is wide. Fortunately, there are methods and strategies that can simplify the process. One of the easiest to apply is the contribution margin and the contribution margin ratio.
When looking at contribution margin ratio examples, the contribution margin seeks to determine how much of each sales dollar goes toward paying for fixed expenses and contributing to profits. It is calculated using this formula:
Contribution margin = sales – variable costs
The contribution margin ratio takes things one-step further by calculating the contribution margin as a percentage of sales. As we will show later, the ratio makes it easy to determine how many additional units of sales are required to make a certain profit target. The formula for calculating the contribution margin ratio is as follows:
Margin contribution ratio = (Contribution Margin / Sales) × 100
Contribution Margin Ratio Examples
Lets look at some examples of using this ratio. First, we will need some numbers. Consider the following data for FiwiBooks Ltd.
Sales (1,000 units @ $14) - $14,000
Less Variable expenses - $6,500
Fixed Expenses - $2,000
First we will need to calculate the contribution margin.
Contribution margin = sales – variable costs = 14,000 – 6,500 = 7,500
We can now calculate the contribution margin ratio.
Contribution margin ratio = (contribution margin / Sales) × 100 = (7500/14000) x 100 = 53.57%
These figures tell us that for every dollar of sales just over 53% goes toward paying for fixed expenses, while the rest contributes to net profits. At present, the company makes $5,500 in profits (14,000-6,500-2,000). To calculate how much sales the company will need to make in order to exceed $10,000 in profits, we divide the amount of additional profit that is needed by the margin ratio.
To realize $10,000 in profits, FiwiBooks will need $4,500 in additional profits, (10,000 – 5500). Therefore, to make the additional $4,500 they will need to increase sales by $9,692 (4,500/0.5357). Since each book retails for $14, the company will need to sell an additional 692 ($9,692/14) books to breach the $10,000 profit target.
Limitations of the Contribution Margin Ratio
The contribution margin assumes that fixed costs will remain constant even while sales and production levels are increasing.
Unfortunately, there is a practice of using the contribution margin to calculate target sales numbers without considering the need to purchase new equipment and employing additional staff, which in and of itself, may cause fixed costs to rises as well. In other words, management must consider how increasing sales will affect other production variables, not just variable costs, but all expenses that may need to be incurred to increase capacity.
While these contribution margin ratio examples show how to determine break-even levels, they are most often applied and most valuable when used to determine how many additional units of sales will need to be made to produce a certain level of profitability. In other cases, the contribution margin may be invaluable in helping mangers to determine which of several products to focus on to generate the most profits.